Morningstar.com
Is Your Fund Selling for the Right Price?
Wednesday March 17, 6:00 am ET
By Emily Hall
Dear Analyst,
Your recent analyst report on Fidelity Diversified International mentioned the fund's "fair-value pricing" policy. I can't find out exactly what that is and how it works. Can you help?
Paul C.
I'm happy to help! (That's my job, after all.)
One of the side effects of the mutual fund scandal is that investors are learning a lot of new vocabulary words. "Late-day trading," "stale-price arbitrage," and "fair-value pricing" are just a few of the many terms that have become commonplace in the wake of the various state and federal investigations.
It turns out that "fair-value pricing" and "market-timing" can have a lot to do with each other. In particular, funds that fail to employ fair-value pricing may be the target of a particular type of market-timing called stale-price arbitrage. And as we've all learned from the scandal, market-timing can hurt long-term shareholders like you and me.
The issue of fair-value pricing (FVP) stems from a quirk of mutual funds: Their prices--the value of all the securities in their portfolio divided by the number of fund shares--are released only at the close of the U.S. trading day. So if you live in New York and you place your purchase request at 9:30 a.m. or at 3:30 p.m., you'll be charged that same end-of-day price.
However, funds that invest in foreign securities may not always reflect the most up-to-date prices. Why would that be? Well, let's use a scenario: Let's consider a fund that invests exclusively in the Asia-Pacific region. Because of the time difference between Asia and the United States, the trading in Asian markets comes to an end when it is morning in the United States. Now let's say that on this particular day, the Asian markets closed flat. (In other words, they didn't gain or lose very much.) Since the Asian markets are now closed, the Asia fund's price would essentially be set at that time--although the fund's NAV won't be released until the end of the trading day. Then, let's say that the Federal Reserve Board sends out a press release at 1 p.m. Eastern time announcing that it is cutting interest rates by 1.00%. That huge rate cut makes the U.S. market go crazy, and the S&P 500 Index closes up a mammoth 5% for the day--with nearly all that gain occurring in the afternoon hours in the United States.
Well, as a market-timer, I would be able to able to assume that the Asian markets are going to gain a lot tomorrow thanks to the big gain in the United States today. (Foreign markets often react to action on U.S. exchanges on the following day.) But since the Asian markets closed hours ago, I can still buy that Asia fund today's cheaper prices--as long as the fund I'm tracking doesn't use fair-value pricing. Then, I can turn around and sell tomorrow for a nearly assured profit.
That's where fair-value pricing comes in. Let's say that the same Asia-Pacific fund we were talking about in our scenario does use FVP. After a market-moving event, like a rate cut, a fund company committee (or its pricing service) would meet near the end of the U.S. trading day to try and set prices that take into account the expected gain that the Asian markets will experience tomorrow. In other words, the FVP committee would likely price the fund's stocks higher than they would have been priced without using fair-value pricing. That works to deter arbitragers since they can't capitalize on the "stale" prices.
Of course, FVP is a tricky thing, and it can be hard to do well. If the fund company guesses wrong and shares in Asia don't rise very much, then it may be overpriced and suffer a decline the next day.
Despite the challenges of fair-value pricing (which my colleagues Bridget Hughes and Gregg Wolper wrote about in detail in their recent articles), some fund companies have employed the practice of FVP for several years now. T. Rowe Price and Fidelity, for example, have been known to use fair value pricing on their foreign funds. And now that the scandal has turned an eye on these practices, many other fund companies have followed suit.
If you invest in one or more foreign funds, it would behoove you to know if your fund employs fair-value pricing. Funds that use FVP are likely to be better equipped to protect long-term shareholders from market-timers. (Another practice that can protect long-term shareholders is the implementation of a short-term trading fee, which can also scare off market-timers.) Unfortunately, fund companies aren't required to disclose whether they use fair-value pricing. That's why we've started to include information about foreign funds' FVP policies in the strategy section of our Fund Analyst Reports. We make sure to ask fund managers and fund companies about their FVP policies during our interviews and on-site visits, and then we relay the information to our readers. |
